Flexible Budgets Variances and Management Control I Chapter

Learning Objective 1 Distinguish a static budget from a flexible budget. © 2003 Prentice

Static and Flexible Budgets Static Budget Flexible Budget Based on Planned level of output at start of the budget period Budgeted revenues and cost based on actual level of output © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -3

Static Budget Example Assume that Pasadena Co. manufactures and sells dress suits. Budgeted variable costs per suit are as follows: Direct materials cost $ 65 Direct manufacturing labor 26 Variable manufacturing overhead 24 Total variable costs $115 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -4

Static Budget Example Budgeted selling price is $155 per suit. Fixed manufacturing costs are expected to be $286, 000 within a relevant range between 9, 000 and 13, 500 suits. Variable and fixed period costs are ignored. The static budget for year 2004 is based on selling 13, 000 suits. What is the static-budget operating income? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -5

Static Budget Example Revenues (13, 000 × $155) $2, 015, 000 Less Expenses: Variable (13, 000 × $115) 1, 495, 000 Fixed 286, 000 Budgeted operating income $ 234, 000 Assume that Pasadena Co. produced and sold 10, 000 suits at $160 each with actual variable costs of $120 per suit and fixed manufacturing costs of $300, 000. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -6

Static Budget Example What was the actual operating income? Revenues (10, 000 × $160) Less Expenses: Variable (10, 000 × $120) Fixed Actual operating income $1, 600, 000 1, 200, 000 300, 000 $ 100, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -7

Static-Budget Variance Example What is the static-budget variance of operating income? Actual operating income $100, 000 Budgeted operating income 234, 000 Static-budget variance of operating income $134, 000 U This is a Level 0 variance analysis. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -8

Static-Budget Variance Example Static-Budget Based Variance Analysis (Level 1) in (000) Static Budget Actual Variance Suits 13 10 3 U Revenue $2, 015 $1, 600 $415 U Variable costs 1, 495 1, 200 296 F Contribution margin $ 520 $ 400 $120 U Fixed costs 286 300 14 U Operating income $ 234 $ 100 $134 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 -9

Learning Objective 2 Develop a flexible budget and compute flexible-budget variances and sales-volume variances. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 10

Steps in Developing Budgets Flexible Step 1: Determine budgeted selling price, variable cost per unit, and budgeted fixed cost. Budgeted selling price is $155, variable cost is $115 per suit, and the budgeted fixed cost is $286, 000. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 11

Steps in Developing Budgets Flexible Step 2: Determine the actual quantity of output. In the year 2004, 10, 000 suits were produced and sold. Step 3: Determine the flexible budget for revenues. $155 × 10, 000 = $1, 550, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 12

Steps in Developing Budgets Flexible Step 4: Determine the flexible budget for costs. Variable costs: 10, 000 × $115 = $1, 150, 000 Fixed costs 286, 000 Total costs $1, 436, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 13

Variances Level 2 analysis provides information on the two components of the static-budget variance. 1. Flexible-budget variance 2. Sales-volume variance © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 14

Flexible-Budget Variance (Level 2) in (000) Suits Revenue Variable costs Contribution margin Fixed costs Operating income Flexible Budget 10 $1, 550 1, 150 $ 400 286 $ 114 Actual 10 $1, 600 1, 200 $ 400 300 $ 100 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Variance 0 $ 50 F 50 U $ 0 14 U $ 14 U 7 - 15

Flexible-Budget Variance Actual quantity sold: 10, 000 suits Flexible-budget variance $14, 000 U Actual results operating income $100, 000 Flexible-budget operating income $114, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 16

Flexible-Budget Variance Total flexible-budget variance = Total actual results – Total flexible budget for actual sales level © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 17

Flexible-Budget Variance Selling price Variable cost Contribution margin Actual Amount $160 120 $ 40 Budgeted Amount $155 115 $ 40 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 18

Flexible-Budget Variance Why is the flexible-budget variance $14, 000 U? Selling-price variance Actual variable costs exceeded flexible budget variable costs Actual fixed costs exceeded flexible budget fixed costs Total flexible-budget variance $50, 000 F 50, 000 U 14, 000 U $14, 000 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 19

Sales-Volume Variance (Level 2) in (000) Suits Revenue Variable costs Contr. margin Fixed costs Operating income Flexible Budget 10 $1, 550 1, 150 $ 400 286 $ 114 Static Sales-Volume Budget Variance 13 3 U $2, 015 $465 U 1, 495 295 F $ 520 $120 U 286 0 $ 234 $120 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 20

Sales-Volume Variance Actual quantity sold: 10, 000 suits Sales-volume variance $120, 000 U Flexible-budget operating income $114, 000 Static-budget operating income $234, 000 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 21

Sales-Volume Variance Actual sales unit – Master budgeted sales units 13, 000 – 10, 000 = 3, 000 × Budgeted contribution margin per unit $40 = Total sales-volume variance $120, 000 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 22

Budget Variances Level 1 Level 2 Static-budget variance $134, 000 U Flexible-budget variance $14, 000 U Sales-volume variance $120, 000 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 23

Learning Objective 3 Explain why standard costs are often used in variance analysis. ©

Standards Pasadena’s budgeted cost for each variable direct cost item is computed as follows: × Standard input allowed for one output unit Standard cost per input unit © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 25

Standards 4. 00 square yards allowed per output unit at $16. 25 standard cost per square yard. Standard cost per output unit 4. 00 × $16. 25 = $65. 00 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 26

Standards 2. 00 manufacturing labor-hours of input allowed per output unit at $13. 00 standard cost per hour. Standard cost per output unit 2. 00 × $13. 00 = $26. 00 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 27

Learning Objective 4 Compute price variances and efficiency variances for direct-cost categories. © 2003

Actual Data Direct materials purchased and used: 42, 500 square yards at $15. 95 Cost of direct materials = $677, 875 Labor hours: 21, 500 at $12. 90 Cost of direct manufacturing labor = $277, 350 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 29

Price Variance Example Direct-material price variance = Actual price – Budgeted price = ($15. 95 – $16. 25) × 42, 500 = $12, 750 F × Actual quantity © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 30

Price Variance Example Direct-labor price variance = = Actual price – Budgeted price × Actual quantity ($12. 90 – $13. 00) × 21, 500 = $2, 150 F © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 31

Price Variance Example What is the journal entry when the materials price variance is isolated at the time of purchase? Materials Control 690, 625 Direct-Materials Price Variance 12, 750 Accounts Payable Control 677, 875 To record direct materials purchased © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 32

Efficiency Variance Example Direct-material efficiency variance = = Actual quantity – Standard quantity × Standard price (42, 500 – 40, 000) × $16. 25 = $40, 625 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 33

Efficiency Variance Example Direct-labor efficiency variance = = Actual quantity – Standard quantity × Standard price (21, 500 – 20, 000) × $13. 00 = $19, 500 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 34

Efficiency Variance What is the journal entry to record materials used? Work in Process Control 650, 000 Direct-Materials Efficiency Variance 40, 625 Materials Control 690, 625 To record direct materials used © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 35

Price and Efficiency Variance What is the journal entry for direct manufacturing labor? Work in Process Control 260, 000 Direct Manufacturing Labor Efficiency Variance 19, 500 Direct-Manufacturing Labor Price Variance 2, 150 Wages Payable 277, 350 To record liability for direct manufacturing labor © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 36

Flexible Budget Material Variance Example Actual Cost $677, 875 AQ × BP 42, 500 × $16. 25 $690, 625 $12, 750 F BQ × BP 40, 000 × $16. 25 $650, 000 $40, 625 U $27, 875 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 37

Flexible Budget Labor Variance Example AQ × BP 21, 500 × $13. 00 $279, 500 Actual Cost $277, 350 $2, 150 F BQ × BP 20, 000 × $13. 00 $260, 000 $ 19, 500 U $17, 350 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 38

Variance Analysis Level 1 Static-budget variance Materials $167, 125 F Labor 60, 650 F Total $227, 775 F Level 2 Flexible-budget variance Materials $27, 875 U Labor 17, 350 U Total $45, 225 U Level 2 Sales-volume variance Materials $195, 000 F Labor 78, 000 F Total $273, 000 F © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 39

Variance Analysis Level 2 Flexible-budget variance Materials $27, 875 U Labor 17, 350 U Total $45, 225 U Level 3 Price variance Materials $12, 750 F Labor 2, 150 F Total $14, 900 F Level 3 Efficiency variance Materials $40, 625 U Labor 19, 500 U Total $60, 125 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 40

Learning Objective 5 Explain why purchasing performance measures should focus on more factors than just price variances. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 41

Performance Measurement Using Variances Effectiveness is the degree to which a predetermined objective or target is met. Efficiency is the relative amount of inputs used to achieve a given level of output. Variances should not solely be used to evaluate performance. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 42

When to Investigate Variances When should variances be investigated? Subjective judgments Rules of thumb as “investigate all variances exceeding $10, 000 or 25% of expected cost, whichever is lower. ” © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 43

Learning Objective 6 Integrate continuous improvement into variance analysis. © 2003 Prentice Hall Business

Continuous Improvement Assume that the budgeted direct materials cost for each suit that Pasadena Co. manufactures is $65. Pasadena Co. wants to implement continuous improvement budgets based on a target 1% materials cost reduction each period. What should the budgeted cost be for the next 3 subsequent periods? © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 45

Continuous Improvement Prior Period Budgeted Amount This Period: – Period 1: $65. 00 Period 2: $64. 35 Period 3: $63. 71 Reduction in Budget – $0. 650 $0. 644 $0. 637 Revised Budgeted Amount $65. 00 $64. 35 $63. 71 $63. 07 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 46

Learning Objective 7 Perform variance analysis in activity-based costing systems. © 2003 Prentice Hall

Flexible Budgeting and Activity-Based Costing Materials costs and direct manufacturing labor costs are examples of output-unit level costs. Batch-level costs are resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 48

Flexible Budgeting and Activity-Based Costing Denver Co. produces metal planters (MP). Assume that material-handling labor costs vary with the number of batches produced rather than the number of units in a batch. Material-handling labor costs are direct batch level costs that vary with the number of batches. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 49

Flexible Budgeting and Activity-Based Costing Static Budget Units produced and sold 18, 000 Batch size 180 Number of batches 100 Material-handling labor-hours per batch 5. 00 Actual Amounts 15, 660 174 90 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 5. 20 7 - 50

Flexible Budgeting and Activity-Based Costing Total labor-hours Cost per material-handling labor-hour Total material-handling labor cost Static Actual Budget Amounts 500 468 $14. 00 $14. 50 $7, 000 $6, 786 © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 51

Flexible Budgeting and Activity-Based Costing How many batches should have been employed to produce the actual output units? 15, 660 units ÷ 180 units per batch = 87 batches How many material-handling hours should have been used? 87 batches × 5 hours/batch = 435 hours © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 52

Flexible Budgeting and Activity-Based Costing What is the flexible budget for material-handling labor-hours? 435 hours × $14. 00/labor-hour = $6, 090 Flexible-budget costs Actual costs Flexible-budget variance $6, 090 6, 786 $ 696 U © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 53

Price and Efficiency Variances Price variance = ($14. 50 – $14. 00) × 468 = $234 U Efficiency variance = (468 – 435) × $14. 00 = $462 U Total variance © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster $696 U 7 - 54

Learning Objective 8 Describe benchmarking and how it is used in cost management. ©

Benchmarking It refers to the continuous process of measuring products, services, and activities against the best levels of performance. © 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 7 - 56